Building Out the Climate Capital Stack

Co-authored by Mona

We recently announced that we have started to invest from our second climate fund. Much like our first climate fund this is an early stage fund, making initial investments at the seed and Series A stages. Generally these are companies that have something working, whether it is an alpha/beta version of software, or a bench scale system, or an engineering simulation. With the funds raised from us and others at this stage the companies can usually make a lot of progress. For software-only companies that progress usually results in customer traction and there are large pools of capital that can be accessed by these companies. But the climate crisis is a physical problem and many companies that we have backed have a significant hardware component. 

Hardware-heavy companies too can make significant progress:  they can go from a bench system to a prototype system; they can also often find some early customers that will make small exploratory purchases or forward commitments. But then comes a difficult moment in time for these companies: the need to raise money to build a pilot facility in working up to a first-of-a-kind (FOAK) plant. And here is where companies encounter the holes in the climate capital stack: an absence of Pilot/FOAK infrastructure funding and a dearth of Series B capital for such hardware companies.

It is difficult to come up with precise numbers on the sizes of these two holes. Our analysis of data compiled by Climate Tech VC gives the following picture for climate funds raised in 2021 and 2022:

Mid-stage here refers to funds that can lead rounds in pre-revenue climate companies that need significant capital for physical infrastructure. By comparison, the size of the Pilot/FOAK funding need has been estimated to be as large as $150-190 billion by Deanna Zhang, who identified 18,182 climate startups which require such funding. 

Now there are many existing infrastructure funds often with billions of dollars. Between 2017 and 2022, the largest 100 infrastructure funds raised nearly $1 trillion. However, these funds tend to be entirely focused on backing well-established projects, such as solar arrays and wind farms. The deal sizes for these funds are in the hundreds of millions of dollars. The economics of these projects are well understood and the funds are set up to earn small percentage returns on large dollar amounts put to work. Wind and solar infrastructure funding are highly competitive markets and returns reflect that. This means that the funds cannot take on the risks of a Pilot/FOAK facility in a new market, such as Direct Air Capture (DAC). Their economics are such that they cannot support a potential total loss of capital. Of course herein lies a problem not just for startups trying to get a Pilot/FOAK plant financed, but also for the infrastructure funds themselves. In the absence of an innovation pipeline they are all competing over the same set of well understood projects.

How could this massive funding gap be filled? A place to look for inspiration is the massive growth in the venture debt market. Venture backed, cash burning companies historically were not able to access debt at all. Venture lending changed that through funds that were willing to underwrite more risk by also participating in the upside through warrants. Today the venture debt market has grown to over $30 billion in annual financing in the US alone and many companies in the USV portfolio have some amount of venture debt outstanding. Now a lot of that lending emerged during the rise of software startups and in particular SaaS companies, for which underwriting has become quite sophisticated and can make use of revenue based metrics. Underwriting FOAK plants will be more challenging, potentially requiring an in-depth understanding of target markets and technology. It will take more upside to make the overall economics work. In addition, it would help to have concessionary capital from governments absorb some degree of losses (this would be a smart way for governments to deploy a lot of capital quickly into climate innovation while having the allocation decisions managed externally by people with skin in the game).

Another way to generate more upside is to have a Series B fund that sits alongside the Pilot/FOAK fund, in a model that is already being pioneered by firms such as Keyframe, Thirdsphere and Springlane. This fund would invest in parallel and also later exercise pro-rata rights obtained by the Pilot/FOAK fund (funneling some of the economics back). As shown in the chart above, there is a large opportunity for a dedicated Series B Climate Fund. There is an acute shortage of capital at that stage. The data from Climate Tech VC indicates that the $60 billion raised into climate funds in 2021 and 2022 has a barbell distribution with a large percentage going to early stage funds (Pre-seed, Seed and Series A) and most of the rest going to growth stage funds (generally Series C and beyond). Almost all of the billion and multi billion dollar climate growth funds have revenue thresholds. Often these are set at $30 million annual revenues with only a few funds coming down to $10 million or below. For many of the more infrastructure-heavy companies this capital will not be relevant until a Series C or beyond.

There is a unique opportunity at this moment then for a billion dollar Series B Climate fund that collaborates with seed and Series A funds to back companies that are pre or early revenue but have been substantially de-risked (technology progress, market validation, etc.). During the heydays of software companies in the last decade Series B was a poor entry point. Companies were being priced off rapid revenue ramps as if those ramps were going to persist. Often when those companies encountered the inevitable challenges those valuations turned out to have been too aggressive. Here the situation is different. The Series B Climate fund will be able to invest in companies that have made progress on complicated engineering and technology problems but have little to no revenues while facing relatively large capex needs. Valuations will be attractive until this hole in the capital stack has been filled.

These kinds of large scale shifts in markets are relatively infrequent. In our research we came across some pioneering firms that are already providing the type of capital outlined in this post. Examples of those include Breakthrough and Prime Coalition (on the catalytic side) and Keyframe, Third Sphere, Springlane Capital (on the commercial side). Given the size of this funding gap, there is room for many more Pilot/FOAK and Series B Climate pre-revenue funds. As outlined above, ideally these funds sit side-by-side inside the same firm. 

While we have identified this opportunity, we don’t believe it is a stylistic fit for USV. But we are interested in helping more such funds come about. So if you are working on starting such funds or know teams that are, we would love to be in touch.